One of the questions many business owners struggle to answer is, “How much does it cost us to produce that?”
It’s basic, but in truth the issue of profitability and cost is quite a complicated question and one we see is often unknown or unclear for businesses. Many companies are profitable, but what’s holding them back from being fully profitable? Typically, the barrier is tied to not having a complete picture of actual cost — one that includes everything that is required to calculate the true cost of production or to provide one hour of service.
As with many financial analyses, there’s a formula for that. If you’re seeking to boost margins, here are six questions to ask yourself or your controller to help you uncover and then reduce the true cost of operations.
Are you suffering from data haze?
Numbers are a means to measure growth and change. But in the rush to measure everything that can be measured, sometimes big data can provide so many data points that it obscures the performance metrics that indicate profitability. It’s also a waste of time to assign codes and categories to dozens of line items and run all those reports if they’re not going to lead to meaningful action. The amount of time we tend to spend gathering information can be tremendous and at the end of the day, inefficient. So ask your team whether they’re looking at numbers that tie to the true business drivers, and what meaningful steps have been taken in the past two months based on each of the reports on their desks?
Are your one-time costs occurring more than one time?
We saw this frequently during the downturn, but it’s continuing even today. There are some cash outlays that we tend to think of as one-time expenses: for example, severance, temporary employment, headhunter fees, plant closing costs and employee relocation costs. It’s tempting to think of these as special items that don’t reoccur, yet it’s not an exception to the rule if it continues to show up on your expense reports. These expenses should more accurately be considered as part of a new run rate of ongoing regular costs, not a one-time expense.
Is it all in there?
Many companies have automatically set aside and exclude some costs as general overhead when they actually are part of production and should be included. For example, IT departments are routinely labeled overhead as a group. However, closer inspection reveals IT is actually involved in inventory management, price changes, coding and other ongoing production tasks. The IT team at many companies is so involved in the production process that you really can’t get products out the door without them. If your IT department’s annual budget is $300,000, but they spend 20 percent of their time on tasks to keep the shop floor running, allocate $60,000 to product costs. Many times we even see this applying to company management in small companies where executives with VP titles on the door are actually involved in inventory procurement and shop production tasks. So ask yourself, are IT and other departments being allocated fully to the general administration budget when a portion should be allocated to production?
Are you overlooking the hidden cost of inventory?
As auditors, we love looking at balance sheets because this tells the true financial story of a business. However, company executives can get so focused on profit-and-loss reports that they often overlook the balance sheet, which can oftentimes uncover inventory costs that are cutting into profit margins. Companies use a variety of methods to calculate cost of inventory — what you paid for inventory now, what you expect to pay in two months, what you expect to pay next year, etc. If the balance sheet doesn’t reflect inventory levels at the prices you’ve actually paid, the income statement won’t reflect true costs. That will end up skewing the picture of what your gross margins truly are.
Is that cost really fixed?
Too often business owners believe that certain costs are fixed and cannot be changed. In today’s business world there are a plethora of financial instruments and consultants to help business owners lower what have historically been considered as fixed, non-negotiable costs. Examples include freight logistics consultants, mobile phone consultants, electricity usage advisers, government program/grant seekers, etc. Many business owners think they can’t change their parcel delivery service charges or cut their cell phone bills. Maybe they can reduce interest costs by turning to alternative financing to build that new facility. I’ve seen some energy cost-reduction engagements lead to six-figure savings by helping an owner manipulate the shop floor or change lighting systems.
Are you ignoring costs that can’t be seen in accounting data?
Inefficient processes in the plant don’t show up on the P&L report or balance sheet, but they still eat into your gross margins. What are you doing in 10 steps that can be reduced to eight? Are you holding excess inventory? What are you losing in production time from not having ergonomic tools or equipment in place, or from having outdated software that forces people to manually do what can now be automated?
Here’s a story: A client needed to finish and buff a 15-foot tall piece of equipment as one of its final production processes, a task that was completed with the help of stepladders moved around the unit. An employee suggested an idea that led to the client purchasing a customized, ergonomic system that used mobile scaffolding with a floor that raises and lowers. This created a much faster and safer way to finish the unit. Most of us have these processes in our companies — methods of doing business we’ve done for years, reports we’ve run that are no longer necessary, routine tasks that can be automated, minimized or eliminated completely. None of that shows up on an accounting report, but it certainly adds costs and eats into profitability margins.
A side note to consider: Don’t be afraid to ask employees for improvement ideas. The suggestion box is an old concept, but there is no shortage of examples when companies see real profitability gains that came not from the corner office, but from the shop floor.
Certainly we can create more questions, but these are perhaps the “Big Six” that will provide the fastest path to uncovering tasks and practices that drag down your profit margins. Clarity and focus are not only good concepts for driving the company, they’re also good principles for finding ways to boost your overall profitability.
Eric German, CPA, M.Acc., is Senior Manager with Bober Markey Fedorovich. He joined the firm in 2013 after 10 years of professional experience, including time with Ernst & Young. Previously serving as an assistant controller at a $10+ billion private equity investment manager and as an assurance manager at a Big 4 accounting firm, Eric became well-versed in leading assessments and projects that support C-suite decisions by recognizing key performance drivers, business trends and industry developments. Eric works with clients that have very complex needs, from carving out financial statements for divestitures to purchase accounting for acquisitions. Eric also has extensive experience helping his clients navigate some of the most complex areas of U.S GAAP such as restructurings, equity compensation and complex financial instruments. He graduated from Bowling Green University where he earned both his bachelor’s and master’s degrees in accounting.